OVER THE PAST 15 YEARS, an important and underappreciated shift has occurred in U.S. pension policy. The change has been away from "defined-benefit" plans -- company pension funds that pay a guaranteed benefit based on years of employment -- toward "defined-contribution" plans -- a remarkable, and highly popular, public-policy innovation. In December 1997, assets in all defined-contribution plans, such as 401(k)s, for the first time equaled those in defined-benefit plans, at about $ 1.5 trillion each. Defined-contribution plans now cover about 43 percent of U.S. workers, while defined-benefit plans cover a mere 25 percent.
Employees love 401(k)s. They like having ownership and control over their money. The accounts are transparent -- employees can see how much they have, how they've invested it, and how it's doing, usually 24 hours a day via telephone or Web site. They're not penalized for changing jobs. They can take loans against their money, or withdraw it for medical expenses, education, or to buy a first home. And the security of their retirement doesn't depend on their company, or the Social Security system, being solvent when they retire.
Employers, too, love 401(k)s, which don't require them to play a paternalistic role in their employees' lives or to carry the long-term liability and funding risk of defined-benefit plans. And 401(k)s are much less complex to administer. Contributions and cash flow are predictable. And they help to attract employees.
On top of that, the seismic shift from defined-benefit to defined-contribution has had a massive beneficial impact on the U.S. economy. Everyone has heard about the "wall of money" that has poured into financial markets, as the Baby Boomers have begun saving for retirement: It has come largely through 401(k)s. Most analysts agree that this is no small part of the explanation for the astonishing rise in U.S. equity markets. Just since the end of 1994, the Standard & Poor's 500 index has seen a 150 percent jump, generating about $ 5 trillion in wealth for individual investors.
But the boom in defined-contribution plans has other benefits as well. It means that more people are covered by employer-sponsored pension plans, since smaller companies that couldn't afford to administer defined-benefit plans have put defined-contribution plans in place. Defined-contribution plans also enhance labor-market flexibility, as workers need not fear losing benefits by switching jobs or working past retirement age.
Even more important, the rise of defined-contribution plans has important implications for the allocation of capital. The large defined-benefit plans have to pay the pensions of workers who are retiring in 20 years, in 10 years, next year, and those who have retired already. They have to invest in bonds and in safe, slow-growth stocks that pay high dividends to meet their ongoing funding needs. And they don't compete intensely on performance, since they have a captive flow of funds and are seldom replaced unless they turn in successive years of underperformance.
By contrast, workers who aren't touching the money in their defined-contribution plans for two or three decades can benefit from the long-term outperformance of stocks over bonds. Moreover, they care about capital appreciation, not dividend income. In addition, the mutual funds through which they're investing compete rabidly on performance, knowing investors can switch with one toll-free call. That means workers will invest, through mutual funds, in an Intel, a Cisco Systems, or a Microsoft -- fast-growing companies that reinvest in their burgeoning businesses rather than pay dividends (their combined dividend yield is 0.12 percent). Intel spends billions on each new semiconductor plant -- it can't pay a big dividend. But it's one of the most successful companies, and most successful stocks, in America -- and it created 44,000 jobs between 1987 and 1998.
So the rise of defined-contribution plans -- the 401(k) and its cousin, the IRA -- has made labor markets more flexible, fed the stock-market boom, and sharply enhanced the world-beating competitiveness of the U.S. economy. It is no exaggeration to say that the introduction of the 401(k) was one of the most beneficial, prescient, and enlightened steps taken by U.S. policymakers in the past two decades -- and it is one about which no policymaker can boast.
The fact is, the 401(k) essentially was inadvertent. It sprang from a 1978 provision in the Internal Revenue Service Code that allowed, but didn't encourage, workers to contribute bonuses and profit-sharing awards on a pre-tax basis to retirement accounts. In a stunning illustration of the dynamic, unpredictable nature of progress, companies and workers began exploiting the obscure provision. In 1981, the IRS ruled that pre-tax regular wages could be contributed to a 401(k), and the land rush began. It's estimated that the total assets in defined-contribution plans will have mushroomed at a compound annual growth rate of 14 percent between 1975 and 2001.
This was not the result of any central planning, any design by bureaucrats or politicians. No think tank came up with the idea, no one crusaded for it on the Hill, used it in a campaign spot, or wrote his congressman about it. It doesn't even have a hokey acronym. It was simply the product of millions of individuals' decisions about their own money, their own retirement, their own life.
As the debate over fixing Social Security -- the ultimate defined-benefit plan -- grinds on, there are lessons for policymakers in the history of the 401(k). This wonderfully successful reform was neither planned nor promoted, but has become hugely popular nonetheless. Rather than continue searching for the big legislative fix to address the shortcomings of the last big legislative fix, perhaps we should build on what we already have in the 401(k). Instead of spending untold billions on the compulsory, centrally planned system that's gasping for air, why not foster the thriving alternative that allows people to make their own decisions? A highly successful and well-liked program that pays significant benefits to employees, employers, and the economy as a whole should be encouraged and expanded -- even if nobody in Washington thought it up.
Lee Harriss Roberts works for a U.S. investment bank in London.